ARBOR OUTLOOK: Chinese markets, Zhou Xiaochuan and John Prine

Wednesday

“I’m cold and I’m tired and I can’t stop coughin’ … Long enough to tell you all of the news.” — “Often Is A Word I Seldom Use,” as performed by John Prine

“The main problem is that corporate debt is too high,” said the central bank governor. The speaker also warned of the growing risks from excessive financial leverage, risks that are “hidden, complex, sudden, contagious and hazardous.” Sounds scary, right?

So which Federal Reserve member made the above statements? Janet Yellen? Incoming Fed Chairman Jerome Powell? The young, hard-charging Minneapolis Fed President Neel Kashkari? These thoughts actually emanated from People’s Bank of China Governor Zhou Xiaochuan and were directed at lawmakers in his home country. In a place where the facade of economic and political stability is highly valued and public criticism of the government is strongly frowned upon, his warnings should carry extra weight.

Who woulda’ thunk it? Just a few short years ago, China was considered one of the world’s most financially solvent and fiscally responsible countries. Following the Great Recession, China was the deep-pocketed growth engine of the world. In many ways it still is. However, much of the growth in China since the financial crisis has been spurred by massive amounts of leverage and borrowing, not unlike the debt-fueled years in the United States that led to the crash.

Now, China is hitting a growth wall. Rising standards of living and higher wages, while enriching the lives of ordinary people, make their labor much less competitive. Companies are increasingly turning to countries with cheaper labor, like Indonesia or Vietnam. And an aging population means there’s simply less growth to be had regardless of economic competitiveness. But the Chinese government has promised its people growth, so growth there must be. Unfortunately, most of the growth today is “juiced” by incredible amounts of leverage.

China’s debt to GDP ratio, a bellwether of a country’s overall financial health, is now among the highest in the world. Speculation in their stock and property markets has reached levels that would make the pre-2008 house flippers look like conservative investors. Much of that speculation is fueled by cheap credit, which the Chinese government has aided through its policies. Now those policies are unlikely to be as supportive of ever-increasing debt levels.

Forgetting the obvious risks the Chinese economy faces from an abrupt policy shift and a potential debt bubble bursting, the risks to the broader global financial system are growing. There is a limit (as the United States discovered in 2008) to how much debt-led growth can occur before it begins to weigh too heavily on the economy. After all, as Zhou Xiaochuan recently wrote, “high leverage is the ultimate origin of macro financial vulnerability.”